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HAMISH MCRAE: Markets sceptical of Government ability to manage economy

HAMISH MCRAE: Markets are deeply sceptical of Government’s ability to manage economy, and new PM will have to live with that judgment

We will have a new Prime Minister and a new Cabinet this week. The PM has won the confidence of the rather small electorate of Tory members. 

The new Government now has to win the confidence of a vastly larger one: that of the global financial markets. For it will face a brutal truth. The markets are deeply sceptical of its ability to manage the economy successfully, and the Government will have to live with that judgment whether it is justified or not. 

To catch a feeling for that scepticism, look at what has happened to sterling and gilt yields. The pound has fallen sharply against the dollar and is below $1.16, the lowest since March 2020. 

Spin of the wheel: The new Government has to win the confidence of the global financial markets

True, that is partly a function of the dollar’s safe haven status, for the euro is down to parity and the yen is at a 24-year low. But sterling has also fallen against the euro in the past few days and there are dire forecasts that it will fall further. As for gilts, the ten-year yield has risen to 2.9 per cent, the highest since 2013. All bond yields have risen sharply in the past few days, with the equivalent US treasuries at 3.2 per cent and German bunds at 1.5 per cent. 

But whereas almost all other sovereign bond yields are slightly lower than their previous peak in June, UK yields are higher. In relative terms, the UK is in a less favoured position than it was a couple of months ago. 

This matters for very practical reasons. A weak currency imports inflation. If the pound were back above $1.35 as it was in January, we would be buying oil that much more cheaply and fuel at the pumps would be around 150p a litre. Higher inflation, quite aside from eating into our living standards, increases the cost of funding the national debt in two ways. It pushes up the cost of the index-linked portion, while higher interest rates obviously boost the cost of the rest. 

There is a further twist to this uncomfortable tale. The markets now reckon that the peak level for the Bank of England’s rates will be above 4 per cent next summer, way higher than the Bank’s own projection of 3 per cent. 

If the markets prove to be right, this would suggest that a two-year, fixed-rate mortgage would cost more than 5 per cent. But the prospect of these higher interest rates is not attracting money into sterling, in fact rather the reverse. 

Why? I don’t buy the idea of the pound going into some sort of death spiral so that it reaches the all-time low of $1.05 that it fell to in February 1985. Nor do I accept the fear in the markets that the new Government will be irresponsible with the nation’s finances. But their mood has undoubtedly become uglier in the past couple of weeks. So the new Government has to restore confidence. And it has to do so against the background of more general fears that the costs of crushing inflation will lead to a serious global recession next year. 

Rationally, the UK is in no worse position than other developed countries, indeed I would argue better than most. But it will take time to get that message across, and meanwhile, the mood of the markets is more likely to darken than to lift. It will darken partly because as yet the turning point in inflation is not in sight. At the moment, every forecast for inflation is worse than the previous one. Our run in the UK is particularly alarmist, but the same is happening everywhere. However, the surge in inflation is just one element of the wider transition from the world of easy money to, well, rather tighter money. 

Take that surge in bond yields noted above. Prices of bonds move inversely to the yield, so when interest rates rise, their price falls. Last week, the Bloomberg global index of government and investment grade bonds fell by 20 per cent from its January 2021 peak, which technically means there is a bear market in bonds. 

This is the first time this has happened since they started that index in 1990, and on my own quick tally there has not been a bear market in bonds since the 1980s. Money managers have experienced bear markets in equities but not in bonds. 

So it will be a bumpy old ride for our new Government. But the markets would do well not to underestimate the new Cabinet – it will have been working hard on its economic plans for weeks. And whatever our politics, we should wish it well at this crucial time.

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